Mechanics of

Options Markets

Chapter 10
ADMS 4503 Derivatives

Prof. Hamid Arian, PhD, CFA, FRM

Course Created by Prof. Nabil Tahani

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 1
 Types of Options
• Most exchange-traded options are on stocks, indices,
currencies, and futures contracts on commodities
• There are two types of options:

– A call option is a right to buy the underlying asset by a certain

date for a certain price (the strike price)

Payoff  max(ST  K ,0)

– A put option is a right to sell the underlying asset by a certain

date for a certain price (the strike price)

Payoff  max( K  ST ,0)

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 2
 Types of Options
• There are two styles of options
– A European option can be exercised only at the maturity date
– An American option can be exercised at any time until the
maturity date

• Most options are plain vanilla (standard options)

• However, there is a market for exotic options such as:
– Barrier options whose existence depends upon the underlying
asset's price breaching a preset barrier level
– Other exotic options are Asian (or Average) options, Lookback
options, Parisian options, Bermudan options…
– Some exotic options consider a group of assets such as Basket
options whose underlying is a weighted sum or average of
different assets grouped in a basket, Rainbow options…
ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 3
 Options Payoffs
• The option buyer pays a premium to the seller
• The possible option payoffs are as follow, what is the
position in each case?
Payoff Payoff
Long Call Short Call
K
K ST ST

Payoff Payoff

Long Put Short Put

K
K ST ST

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 4
 Profit/Loss Diagrams
• The Profit/Loss diagram on a Long call position if the
strike price K = $100 and the call price is $5

Unlimited Profit
Profit ($)
30

20

10 Terminal
70 80 90 100 stock price ($)
0
-5 110 120 130
Limited Loss

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 5
 Profit/Loss Diagrams
• The Profit/Loss diagram on a Short call position if the
strike price K = $100 and the call price is $5

Profit ($)
Limited Profit
5 110 120 130
0
70 80 90 100 Terminal
-10 stock price ($)

-20

-30
Unlimited Loss
ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 6
 Profit/Loss Diagrams
• The Profit/Loss diagram on a Long put position if the
strike price K = $70 and the put price is $7

Profit ($)
30
Limited Profit
20

10 Terminal
stock price ($)
0
40 50 60 70 80 90 100
-7
Limited Loss

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 7
 Profit/Loss Diagrams
• The Profit/Loss diagram on a Short put position if the
strike price K = $70 and the put price is $7

Profit ($) Limited Profit

Terminal
7 stock price ($)
40 50 60
0
70 80 90 100
-10

-20
Limited Loss
-30
ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 8
 Specification of
Exchange-Traded Options
• The exchange must specify several characteristics of the
options that they trade
– Expiration date: Options can trade on a weekly or monthly basis
– Strike prices: They are spaced $2.50, $5 or $10 apart
– European or American: some exchange-traded options are
European (e.g. on S&P 500), most of them are American (e.g.
stock options, options on S&P 100)
– Call or Put (option type)
• Options have generally short maturities. Longer-term
options are called LEAPS which have maturities up to 3
years

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 9
 Terminology
• Options can be referred to by their Moneyness:
– At-the-money option: would lead to a payoff of zero if exercised
immediately
S0 < K S0 = K S0 > K
– In-the-money option: would lead to a a
positive payoff if exercised now Call OTM ATM ITM
– Out-of-the-money option: would lead Put ITM ATM OTM
to a negative payoff if exercised now

• Option class: All options (calls and puts) on a given

underlying asset, e.g. all calls/puts on Apple stock

• Option series: All options of a given type (calls or puts)

with same maturity and strike price, e.g. all June 175 calls
on Apple stock
ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 10
 Terminology
• Intrinsic Value: is the maximum of zero and the payoff of
the option if it were exercised immediately
– The intrinsic value of a call is max (S – K , 0)
– The intrinsic value of a put is max (K – S , 0)

• An American option must cost at least its intrinsic value.

Why?

• Time Value: is the difference between the option price

and the intrinsic value, it represents the value of future
favorable movements in the underlying asset (see graph
in next slide)

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 11
 Understanding Option Price

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 12
 SELF QUIZ
What is a call option?
A) A right to buy the underlying asset by a certain date for a certain price (the strike price)
B) A right to sell the underlying asset by a certain date for a certain price (the strike price)
C) An obligation to sell the underlying asset by a certain date for a certain price (the strike price)

Solution:
A) A right to buy the underlying asset by a certain date for a certain price (the strike price)

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 13
 SELF QUIZ
Which type of option can be exercised at any time until the maturity date?
A) European option
B) American option
C) Bermudan option

Solution:
B) American option

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 14
 SELF QUIZ
What kind of option considers a group of assets as its underlying?
A) Barrier options
B) Basket options
C) Bermudian options

Solution:
B) Basket options

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 15
 SELF QUIZ
If you have a long call position with a strike price of $100 and a call price of $5, what is your
maximum loss?
A) $5
B) $100
C) $0
Solution
A) $5

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 16
 SELF QUIZ
If you have a short put position with a strike price of $70 and a put price of $7, what is your
maximum gain?
A) $7
B) $70
C) $77
Solution:
A) $7

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 17
 SELF QUIZ
Which of the following options will generally have short maturities?
A) American Options
B) European options
C) Exchange-traded options

Solution:
C) Exchange-traded options

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 18
 SELF QUIZ
What is the intrinsic value of a call option when the underlying asset's price (S) is $120 and the
strike price (K) is $100?
A) $20
B) $0
C) $120
Solution:
A) $20

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 19
 SELF QUIZ
What term represents the value of future favorable movements in the underlying asset?
A) Intrinsic value
B) Time value
C) Option class

Solution:
B) Time value

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 20
 SELF QUIZ
Which of the following terms describes all options of a given type (calls or puts) with the same
maturity and strike price?
A) Option class
B) Option series
C) Moneyness
Solution:
B) Option series

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 21
 SELF QUIZ
An option that would lead to a negative payoff if exercised immediately is known as:
A) At-the-money
B) In-the-money
C) Out-of-the-money

Solution:
C) Out-of-the-money

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 22
 SELF QUIZ
What is the intrinsic value of a call option when the stock price (S) is $150 and the strike price (K)
is $140?
A) $10
B) $20
C) $0
Solution:
A) $10
𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 = max(𝑆 − 𝐾, 0) = max(150 − 140, 0) = $10

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 23
 SELF QUIZ
If the price of a put option is $8 and its intrinsic value is $5, what is the time value?
A) $2
B) $3
C) $13

Solution:
B) $3
𝑇𝑖𝑚𝑒 𝑣𝑎𝑙𝑢𝑒 = 𝑂𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒 − 𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 = $8 − $5 = $3

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 24
 SELF QUIZ
You purchase a call option with a strike price of $50 and a premium of $6. If the stock price at
expiration is $55, what is your profit?
A) $-1
B) $5
C) $1
Solution:
A) $-1
Profit = (Stock price at expiration − Strike price) − Premium = (55 − 50) − 6 = $−1

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 25
 SELF QUIZ
You sold a put option with a strike price of $100 for a premium of $7. What is your maximum
potential gain?
A) $7
B) $100
C) $107
Solution:
A) $7
The maximum potential gain for the seller of the option is the premium received.

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 26
 SELF QUIZ
If you have a short call position with a strike price of $30 and a premium of $2, what is your
break-even point?
A) $28
B) $32
C) $30
Solution:
B) $32
𝐵𝑟𝑒𝑎𝑘 − 𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 = 𝑆𝑡𝑟𝑖𝑘𝑒 𝑝𝑟𝑖𝑐𝑒 + 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = $30 + $2 = $32

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 27
 SELF QUIZ
You purchased a put option with a strike price of $40 for a premium of $4. The stock price at
expiration is $35. What is your profit?
A) $1
B) $0
C) $5
Solution:
A) $1
𝑃𝑟𝑜𝑓𝑖𝑡 = (𝑆𝑡𝑟𝑖𝑘𝑒 𝑝𝑟𝑖𝑐𝑒 − 𝑆𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒 𝑎𝑡 𝑒𝑥𝑝𝑖𝑟𝑎𝑡𝑖𝑜𝑛) − 𝑃𝑟𝑒𝑚𝑖𝑢𝑚 = (40 − 35) − 4 = $1

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 28
 SELF QUIZ
If the strike price of a call option is $60 and the stock is currently trading at $65, the option is:
A) At-the-money
B) In-the-money
C) Out-of-the-money

Solution:
B) In-the-money

𝐼𝑛𝑡𝑟𝑖𝑛𝑠𝑖𝑐 𝑣𝑎𝑙𝑢𝑒 = 𝑆 − 𝐾 = $65 − $60 = $5

which is greater than zero.

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 29
 SELF QUIZ
You sold a European call option with a strike price of $100 for a premium of $10. If the stock price
at expiration is $90, what is your profit?
A) $10
B) $0
C) $100
Solution:
A) $10
Since the option is out-of-the-money, it will not be exercised. Therefore, the seller keeps the entire
premium.

ADMS 4503 – Fall 2023 Prof. Hamid Arian, PhD, CFA, FRM 30